Question

Gloria is a seasoned sales manager with a very large international company. Although she has a great deal of experience with sales, she has little experience with investing. Gloria has been investing in her company’s 401K plan. However, she has decided to invest some extra money on her own. Gloria has $75,000 she would like to invest.

Since she has recently signed up for internet access to a broker, she is allowed a small number of phone calls to a broker at no additional charge to her.

She calls ABC investments and talks with a Mr. Bill. She tells Mr. Bill she would like to invest in stocks and can he recommend the best way to value a company’s stock. Mr. Bill said she should research four companies and using the constant growth model, select the company with the best value.

Company Current stock price 2017 Dividend Average dividend growth Beta

Verizon ? $2.36 2.9% ?

Wells Fargo ? $1.56 1.3% ?

Exxon Mobil ? $3.08 2.7% ?

Macy's ? $1.51 2.4% ?

Duke Energy ? $3.56 2.1% ?

Facebook ? $0 0 ?

  

** You will be required to research each company’s current market price and its beta.

US Treasury Rate 2.388%

S&P Average Return 7%

Answer the following questions.

Calculate the required rate of return using the Capital Asset Pricing Model (CAPM).

Using the constant growth formula (as known as the Gordon Growth Model), calculate the intrinsic value of each stock.

Compare the values you calculated in question 2, do the values closely approximate the stock’s current price? If not why not?

Which stock, using your calculations would you recommend Gloria invest in, and why?

Based on your calculations, is the Gordon Growth Model an appropriate for to be used for valuing stocks? If not why not?

Does, your calculations support the “Market Efficiency” theory?

Answer 1

NOTE: It is assumed that dividends for each of these companies will continue growing at the average growth rate perpetually. Therefore, the Gordon Growth model is the perpetual contant growth model. The Gordon Growth Model Price is referred to as the Intrinsic Stock Price (a measure of the stock's fair value). Also US Treasury Rate is considered to be the risk free rate and S&P Average Return is taken as a proxy for the benchmark rate of return (market risk premium) for usage in the CAPM formula. All stock beta data is taken from Yahoo Finance and all current market price data is taken from Google Finance and/or Bloomberg.

Gloria should typically invest in a stock that has the greatest intrinsic (and not current market value) market value. A large difference between the two, with the intrinsic value being significantly higher than the current market value indicates a grossly undervalued stock thereby making the same a good investment option. The reverse implies a highly overvalued stock apt for a sell off.

In this problem Duke Energy has a high intrinsic value but low market value thereby making it the best stock for Gloria to invest in. Facebook does not pay dividends and hence is ineligible for intrinsic value calculation using the Gordon Growth Model. However, the FB stock can be valued using relative multiples such as PE Ratio, P/BV ratio, EV/EBITDA Ratio. Verizon looks almost correctly valued whereas Well's Fargo appears to be grossly overvalued.Exxon and Macy's are moderately overvalued and undervalued respectively.

Additionally, the intrinsic and market values differ owing to a variety of factors with the prime among them being supply and demand in the market. Supply and demand can be influenced by targeted buying and selling of stocks through cartelized broker/dealer groups. More often than not such operations create artificial price manipulations for the stock.